The Election, The Fiscal Cliff and the S&P 500

By Danny Riley

As a rule MrTopStep stays out of politics. The reason we keep it out of our chat room and off our web site is because we want to remain neutral. I know that sounds like we are ducking the question, but we aren't. It's a very heated topic and we do not want to make anyone upset. 

Over the past several elections I have had some strong feelings about the possible outcomes, but we stayed away from calling a winner. That changed when Obama ran for office. I wrote a big story two months before the election saying that Obama would win by a landslide. I felt strongly that the public was looking for a change. But as we close in on President Obama's re-election bid, we wonder why anyone would want the job in the first place, much less go back for more. As a street guy I am going to say it like it is. I don't believe that anyone that inherited all the domestic and foreign financial problems that started in 2007 could have come up with a fix. As things unraveled, the U.S. economy was hanging by a thread. And yes, the current financial cliff was written into the Bush tax cuts 10 years ago, one of the main reasons for the deficit we have today. I guess people have forgotten about that.

In 41 days the American people will decide who will be running the country for the next four years. Despite all the negatives over the last four years during President Obama's term, the S&P has rallied from the 930 level all the way back to 1465 less than two weeks ago. So where do the problems lie? As we have said many times over the last few years, in the new world order the country can be running a $16tril deficit and have the markets not only overlook it but trade at the highest levels since 2000. As we head into the November election we know politicians are worried about the “fiscal cliff” and the economic turmoil that is going to start up at year end as deep federal spending cuts kick in and the tax cuts lapse. How can it be that the S&P is at its highest level since the end of 2007? It's not as if people didn't see it this budget crisis coming. The writing has been on the wall for a decade. In 2001 Treasury Secretary Paul O'Neill started work on a plan for tax reform. He wanted to make it simpler and cut out a lot of the deductions and make it easier for the government to process. The plan never went anywhere, and instead of a tax overhaul President Bush delivered the tax cuts he promised while running for office.  Bush made two tax cuts, one in 2001 and the other in 2003. Over the next 10 years the tax cuts created deficits that are still piling up today. Both the Democrats and the Republicans are worried about the ramifications of the deep federal spending cuts set to kick in when the tax cuts lapse at year end.

How wrong could they be? In 1999 Bush was the Republican presidential nominee. His primary opponent Steve Forbes had promoted a 17% flat tax. Bush had a plan too and that was to cut taxes for all Americans. He said that Americans had been overcharged and on our behalf he was going to give everyone a refund. The plan forecast a federal budget surplus of $5.6bil in 2011. I have never pretended to be a smart man, but as traders we make educated guesses all day long and somehow the Republicans didn't have their numbers right. An extended tax cut with over 13 mil people out of work and 48mil people on food stamps in the U.S. combined with record poverty levels. The plan was not working. In 2002 the economy was weak, and the country was already at war in Afghanistan. Instead of a surplus in 2002 the federal government ran a -$158bil deficit. In 2005, two years into the war in Iraq, Congress extended the tax cuts, which added -$416bil in new debt. After the credit crisis and recession in 2008, Obama and the Democratic Congress extended and added cuts in an effort to shore up the economy, which helped push the national debt to -$1.1 tril. The total cost of the tax cuts has added over -$6tril to the debt.

At the end of the day it's simple: The United States is broke. After a full decade of refusing to listen,  Washington is not only out of money but has completely lost the faith of the American people. Many people knew it was coming and just didn't want to talk about it while others added to it, but now it's time to face the reality of what a real shrinkdown looks like and the fiscal cliff. As for who we think will win the election, we think most people are too scared to change. In my lifetime I have never seen a more divided election. There is an old saying that “whatever you do comes back to you” and that is what this election looks like. The cliff is coming, ladies and gentlemen, and it won't matter who gets elected.

MrTopStep Closing Print Video: http://www.mrtopstep.com/28973/

Our view:
Mutual Fund Monday and Turnaround Tuesday were a big flop. Yesterday the S&P had its worst day in three months. The Dow closed down 0.75%, the NASDAQ closed down -1.36% and the S&P was off -1.05%. The S&P futures have been down 5 of the last 7 days and of the two days the S&P didn't close lower, one of the days it closed unchanged and the other it closed fractionally higher, up .20 handles. According to Lowry's, yesterday saw the heaviest wave of selling in months. Short-term indicators are still near overbought levels and say the risk of continued decline remains high. The rebalance numbers are showing billions in stock for sale and the ES is loaded with stops below, and let's not forget the ongoing problems, including anti-austerity protests, in Spain and Greece. Our view is that the ES still has potential on the downside. We lean to selling rallies with tight stops. As always, keep an eye on the 10-handle rule and please use stops.

• It's 6:00 a.m. and the ESZ is down 1 handle at 1436.25, crude is down 85 cents at 90.72 and the EC is trading 1.2878, down 60 ticks.
• In Asia 10 of 11 markets closed lower (Shanghai Comp. -1.24%, Hang Seng -0.83%).
• In Europe 12 out of 12 markets are trading lower (CAC -2.03%, DAX -1.60%).
• Today's headline: “Has the ECB Really Solved the Euro Crisis?”
• Economic calendar: Today: Weekly mortgage apps, new home sales, oil inventories, 5-yr note auction. THURSDAY: Durable goods orders, GDP, jobless claims, pending home sales, 7-yr note auction, farm prices; earnings from Discover Financial, Nike, Accenture, Research in Motion, Micron. FRIDAY: Personal income & outlays, Chicago PMI, consumer sentiment; earnings from Walgreens

• VOLUME: 1.8mil ESZ and 7.2k SPZ traded
• SPREADS: No SPU/Z spreads traded

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UBS: Rebalancing flows should be sizable in equities, moderate in fixed income. We expect US defined benefit funds to do sizable Q3 quarter-end rebalancing. We anticipate $31-36 billion of equity outflows and perhaps as much as $16-19 billion of fixed income inflows. Our calculations suggest that the largest outflows will be from U.S. Large Cap ($18-21 billion), followed by U.S. Small Cap ($7-8 billion). International Developed and EM equities should see smaller outflows around ($3-4 billion) each.  

Chris – there is a super-regional bank called STSA – at one point it was worth $12B cap – as with all banks it got murdered in the crisis and took 80% writedowns – it also recapitalized and did a reverse split – it now trades for 20 bucks against a split adjusted high over $1000 – that's all the firepower you need. you always have to remember rebalancing when looking left.

Elway posted: The view into the quarter end can be seen in two-ways:  the desired view vs. the factual view.  
Desired view: Asset allocation is so overwhelming that Equities have to go down several percent. There is no debate as to this outright desire to see major indices weaken into quarter end as performance is just not that great by the super-majority and this is the optimal outcome for professionals.
Factual View: Sterling, Gold and the SPX 500 have had the smallest percentage retracements since QE was announced, and outside of Gold, neither is a desired asset. Professionals are factually trying to short strength again.
Mexican peso is worth looking at on a quarterly chart, into the end of the week this proxy could break the 2012 trend and that will matter for model driven strategies which make up the majority of HF AUM. With just three months left, 11 vs. the dollar looks a lot more possible than 13.50. Being open to 11 in the Peso makes it pretty hard being short the SPX500, Gold and Sterling as the underbelly of the US Dollar is further exposed beyond the mainstream assets. One can add in S. African Rand (ZAR) for other reasons but the optical search for risk through this lens highlights the breadth that investors are moving out the risk curve.
Conclusion: Too many believe that all risk assets are back to pre-QE3 levels. This is factually incorrect and the majority need to broaden their analysis to look beyond their own sandbox and also look at the true degree of retracements within their own sandbox. Factually, the SP Futures closed Monday 1 point higher than the QE announcement day. Additionally, there is too much focus on quarter-end equity selling based on unproven re-balancing calls from the few that argue they actually have a pension business. This is keeping many from seeing the facts. Point being, since QE was announced, the strongest assets are again showing leadership. After fighting the LTRO in Q1 from the short side on a levered basis and being impaired and now not willing to embrace this upside risk again even on an unlevered basis, can you really see victory into Friday with tomorrow being a Holiday and China being out all next week? Add in the Debate, the China Handover, Employment data coming from such a low base, positive rhetoric developing on the Fiscal Cliff, etc. and the short argument seems pretty shallow….

The issue of Spain and the when vs if remains the key subject of conversation in Europe. The WSJ discussed how the issue may be Merkel and Germany and not necessarily the Rajoy government. According to the Journal, Merkel is reluctant to bring Greek or Spain-related votes before the German parliament as they will risk fracturing her coalition further. All this as questions remain regarding the legality of ECB bond purchases. German parliamentary approval for further aid disbursements is likely, but could be damaging politically for Merkel which is why she wants to see both votes (Spain and Greece) occur simultaneously (this means the Spanish issue could be delayed a few weeks while Greece is sorted out. Recall Friday the speculation that the Greek troika report could be delayed until after US elections on 11/6). this is probably the most important country in Europe at the moment and is facing a big week coming up. By this Fri Spain will have likely published the results of its bank stress test (and identified the industry's total capital needs), published the 2013 budget, and articulated a set of structural economic reforms. All of this is related to but separate from accepting a troika “package” and activating the OMT – Spain appears to be setting itself up to eventually making a request but the ECB won't buy a bond until Rajoy has signed a fresh MOU and that may not happen for a couple weeks. Source

Tuesday started with Case-Shiller premarket housing report showing “home prices are rising, experts say, but not as much as some reports may suggest.” At 8:30CT  236k ESZ and 1k SPZ traded on Globex, trading range 1456.25  – 1450.25 / Monday's RTH's, pit range was 1454.00 – 1445.00, settled at 1451.40 down .5  handles. Today's RTH's gapped 2.5 handles higher to 1454.30-1454.00, traded 1454.50 then down to 1452.20 low before retesting the open range. The uptick in consumer confidence and the Richmond Fed popped the spoos up to 1456.50 by 9:10CT, but the rally lacked conviction on the positive news in a quiet market. The minor retrace held, you guessed it…the opening range as EUBIE posted (09:47:43): potential 2XTOP min charts 1456.00+ and traded a new high by 2 ticks 1456.70 at 10:20 and once again no follow through. Midmorning Jim Chanos said “Apple shares have risen too far, too fast was followed by chatter that the IMF potentially not agreeing to next Greek payment sent the spoos back to and through the opening range by 11:05 and down to a new low of 1451.20 by 11:20. The deterioration continued following  Fed's Plosser: Not Sure Fed Can Do Much if Weak Growth Continues *DJ sending the major indices to new daily lows, sending the spoos down to 1447.10. The SPZ chopped around for a bit then sold off to new lows at 1444.00 as more headlines hit the tape tied to Spanish riots and Greek austerity measures coming to a head soon. After the new low the SPZ traded back above 1446.00 and then got hit by another small sell program(s) down to new lows at 1443.20. mts2 (13:23:14): small sell stops down to 1445.00 small, big under 1442.30 down to 1437.00. The next sell program took the SPZ down through the 1442.20 level down to a new low at 1437.00. After the low the SPZ traded the 1441.00 area and backed off. The closing imbalance showed 22 of the DOW 30 for sale / decent size with the broader market showing $620M to sell with an overall $ 496.91 M / -1,116.05 M. The low of the day,1435.00 traded at 2:57, on the 3:00 cash close the SPZ traded 1437.00 area before settling at 1437.20, down 14.2 handles on the day.

MTS video:  http://www.mrtopstep.com/9-25-2012-george-dowd/  
George Dowd from Newedge USA discusses the recent bounce in the US dollar.  We have gotten the rally in the dollar that we have been looking for over the past few weeks but at this point it seems to lack the strength that would suggest we are immediately on our way to new US dollar highs.    

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CONTRIBUTORS' CORNER

 SPX CHARTS

Bill Blount, Tepid2 ~ Elliott Wave

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DISCLAIMER: The information and data in the following report(s) were obtained from sources considered reliable. Opinions, market data, and recommendations are subject to change at any time. Their accuracy or completeness is not guaranteed and the giving of the same is not to be deemed as an offer or solicitation on our part with respect to the sale or purchase of any commodities or securities. MrTopStep, its officers, directors and its contributors may. in the normal course of business, have position(s) which may or may not agree with the opinions expressed in this report.